Bye Bye, Miss American Pie

by J. Orlin Grabbe

Some people think the time to sell is when everyone
else is selling. That the time to get out of stocks is when
stocks are being dumped, the market is falling, and execution
prices are terrible. That the finest strategy for self-
preservation is to make a mad rush for the door once the
theater has caught fire. After all, they are then doing the "right
thing". They are "financially correct", and their actions are
reinforced by current articles in the Wall Street Journal,
Money Magazine, and commentators on CNBC.

Such people are called Lemmings.

It has been three weeks since I posted "Sell Stocks
Now" on the Internet, on September 15. These have been
three weeks of steady or modestly rising prices for most of the
major stock averages. For those individuals with millions of
dollars in invested in stocks, or institutions with billions, the
intervening time has provided a perfect environment for
liquidation of stock assets, and conversion to other forms of
wealth.

Well, the grace period is over, and the time for
lemmings is at hand. Of course the lemmings have also been
around these past few weeks, rushing to buy more shares of
stock, pulled forward by Dow visions of 6000, 7000, and
onward to 10,000! But much like the bankrupt Credit
Lyonnais, the lemmings will soon be seeking salvation from
their government, and seeking to dump on someone else's
shoulders the consequences of their own actions. It's all part
of the recent "no-regrets" theory of finance, whereby if a
financial contract or asset turns sour, you sue the institution
that sold it to you, claiming you were "victimized". (If the
reverse happens, and you win, you then explain to everyone
what a brilliant investor or financial manager you are.)

It's the same cry-baby mentality evidenced by
corporations which have suffered losses on their interest-rate
swaps. When the swap generates a positive cash flow, the
corporate treasurer is a hero. When the swap generates a
negative cash flow, the board of directors yells "fraud" and
sues the bank. The simplest concepts of risk management and
responsibility have been tossed out the window. After all, we
are all supposed to become billionaires in Bill Clinton's Go-Go
90s--pockets flush with cash, and the booze and lines of
coke waiting in the limo bar.

Are stocks over-valued? Let's do some back of the
envelope calculations. Stocks have historically yielded about
5 percentage points higher in dividend payouts and share buy-
backs than interest payments on bonds. This is considered a
risk premium for the uncertainty inherent in owning stocks as
compared to the fixed payments promised by bond
covenants. If we add 5 percent to the recent yield of about 7
percent on long-term U.S. treasury securities, we obtain a
stock yield of about 12 percent. That is the return that stock
owners would ordinarily require.

But in the year 1995, dividends and stock buy-backs
for publicly traded companies was about $157 billion. The
stock market value of these same firms is currently about $7.2
trillion. This implies a return of about 2.18 percent--more
than five times smaller than it should be.

For stocks to rise to a 12 percent yield would require
the value of traded companies to fall to about $1.3 trillion.
This value, $1.3 trillion, is about 18 percent of the current
market value of $7.2 trillion. If we apply this ratio to the Dow
Jones Industrial Average of about 6000 (although in truth the
Dow is not really representative of the market as a whole), we
obtain a projected Dow of 1090. (That is, $157 billion/.12 =
$1.30833 trillion. Then 1.30833/7.2 =.1817. Finally. 6000 x
.1817 = 1090.)

Of course, the relationships could hold in other ways
without the stock market falling. Dividends and stock buy-
backs could increase to $864 billion in 1996 and subsequent
years. Fat chance. Or bond yields could fall to negative 3
percent. Fat chance again. Or bond yields could fall to zero
and the risk premium on stocks fall to 2 percent, and the Dow
could stay at around 6000. I seriously doubt it. Or bond
yields could fall to zero and the risk premium on stocks fall to
1 percent, and the Dow could rise to 13,000! Think like this,
and you are a lemming.

Something is going to give. In equilibrium (that is, after
the shit has hit the fan), all of these numbers and relationships
will have changed. But one thing is for sure: stock prices are
going to be a lot lower than they are now.